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Default Swaps

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Should people be able to bet on your death? How about your financial failure?

In the United States Senate, Wall Street won one this week when the Senate voted down a proposal to bar the so-called naked buying of credit-default swaps. If that were the law, you could not use swaps to bet a company would fail. The exception would be if you already had a stake in the company succeeding, such as owning a bond issued by the company.

On the other side of the Atlantic, Germany announced new rules to bar just such betting — but only if the creditors were euro area governments.

None of this argument would be taking place if regulators had done their jobs years ago and classified credit-default swaps as insurance.

As it happened, however, clever people on Wall Street followed the prescription laid down by Humpty Dumpty in Lewis Carroll’s “Through the Looking Glass:”

“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”

When Alice protested, Humpty Dumpty replied that the issue was “which is to be master — that’s all.”

The word here is “swap.” It used to mean, well, a swap. In a currency swap, one party will win if one currency rises against another and lose if the opposite happens.

Credit-default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of the swap cannot meet its obligations. The seller of the swap gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.

But the people who dreamed up credit-default swaps did not like the word insurance. It smacked of regulation and of reserves that insurance companies must set aside in case there were claims. So they called the new thing a swap.

In the antiregulatory atmosphere of the times, they got away with it. As Humpty would have understood, Wall Street was master. Because swaps were unregulated, calling insurance a swap meant those who traded in them could make whatever decisions they wished.

That decision, perhaps more than anything else, enabled the American International Group to go broke — or, more precisely, to fail into the hands of the American government. Had it been forced to set aside reserves, A.I.G. would have stopped selling swaps a lot sooner than it did.

The decision that swaps were not insurance meant that anyone could buy or sell them — or at least anyone who could find a counterparty.

Had credit-default swaps been classified as insurance, the concept of “insurable interest” might have been applied. That concept says that you cannot buy insurance on my life, or on my house, unless you have an insurable interest.

Gary Gensler, the chairman of the Commodities Future Trading Commission, recently laid out the history of that concept. It did not exist until the 18th century, when many people — not just owners of ships or cargos — began buying insurance against ships sinking.

More ships began sinking, and insurers cried foul.

The British Parliament outlawed such sales of ship insurance in 1746. Ever since, to buy that insurance you had to have an interest in the ship or its cargo. But it was another 28 years before Parliament extended the idea to life insurance.

So should it be illegal for me to buy credit-default swaps on companies even if I have no other interest in the company? And if I have an interest, should I be limited to buying only enough insurance to cover my exposure? That is, if I own $100 million in XYZ Corporation bonds, should I be able to buy $1 billion in insurance against an XYZ default?

To most on Wall Street, the answer is obvious: let markets function. My buying that insurance will probably drive up the price, and serve as a market indication that people are worried about the credit, which is good because it gives a warning to others.

In any case, it is legal to sell stocks short. That, too, is a way to bet that a company will fail. So what’s the difference?

One difference is that many people short stocks because they deem them overvalued, not because they think the company will go broke. They can profit even if the company does well, so long as the stock does turn out to have been overvalued.

Many who despise credit-default swaps argue that they can be used to force companies to fail. The swap market is thin, and even a relatively small purchase can drive up prices. That very movement may make lenders nervous, cause liquidity to dry up and bring on unnecessary bankruptcies.

There is another, little noticed, possible impact of credit-default swaps. They can undermine bankruptcy laws.

Normally, a creditor wants to keep a company out of bankruptcy if there is a decent chance it can survive. If it does go broke, the creditor wants to maximize the value of the company anyway, so that more will be available to pay creditors.

But what happens if a major creditor, who might even control one class of bonds, has a much larger position in credit-default swaps?

Will he not have interests directly at odds with those of other creditors, since he will do better if the company ends up with less to pay its creditors? Might that creditor seek to, and perhaps be able to, sabotage the company’s best hopes for revival?

At a minimum, such things should be disclosed, but that gets tricky when one part of a megabank (the one with the bonds) claims it is run independently from the other (the one with the swaps).

I don’t know whether it is necessary to treat credit-default swaps like insurance and require someone to have an insurable interest before swaps can be purchased.

The financial reform bill now being debated in the Senate has provisions intended to assure that many of the previous swap abuses are not repeated.

But I do think Germany’s decision was ill considered. First, it may have little effect if other countries do not join in. Buying a swap in New York or London, rather than Frankfurt, will not be difficult.

But the more important issue is one of limiting the targets of credit-default swap purchases. If Germany had simply required buyers of credit-default swaps to have an insurable interest, it would have been standing up for a principle.

By limiting the scope to swaps on debt of euro area governments, the German government sends two signals: it is acting in self-interest, and it is still worried that it may have to finance more bailouts.

Internet Outlook

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Plans to Expand, Speed Up & Control the World Wide Web

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The Internet became an integral part of our life from 1969 on , after its predecessor, ARPANET (Advanced Research Projects Agency Network), switched protocols and turn the network public. ARPANET itself was created over 40 years ago for the U.S. Defense Department.
Between then, when it was mostly used by colleges and research institutions, and now, when you find yourself reading this blog, it took roots in almost every form of communications around the world, even though it failed, so far, to bridge the social divide.
It’s no wonder that, by recognizing its power, governments, courts and freedom advocates are struggling to have a hand on its future. The jury will be out on that one for a long time, but we can already appreciate the implications of such a boundless social network that, by definition, does not recognize any form of geographical border or political barrier.

Take the U.S. FederalCommunications Commission’s 10-year plan, for instance, to establish high-speed Internet as the country’s dominant means of communication, and a federal appeals court’s ruling that the agency lacks authority to regulate and enforce it.
Regardless of what happens next, the agency just launched a broadband test service, to help consumers clock the speed of their Internet, and started collecting data about where broadband is not available. About one-third of Americans have no access to high-speed Internet
service, choose to do without it or cannot afford it.

On another front, advocates for neutrality oppose any official plan to expand the World Wide Web, citing the example of China and some Middle East countries which are already trying to use censorship and control of the Internet as political tools.

All the while, the organization that governs Internet domain names, DNS, began allowing the use of addresses without Latin characters, showing yet another side of the grow of the Internet, particularly in non-
English speaking countries.
The New York Times asked three writers to illustrate the implications of this specific form of Internet expansion. Here’s what they wrote about it.

GODESS ENGLISH OF UTTAR PRADESH

Mumbai, India – A fortnight ago, in a poor village in Uttar Pradesh, in northern India, work began on a temple dedicated to Goddess English. Standing on a wooden desk was the idol of English — a bronze figure in robes, wearing a wide-brimmed hat and holding aloft a pen. About 1,000 villagers had gathered for the groundbreaking, most of them Dalits, the untouchables at the bottom of India’s caste system. A social activist promoting the study of English, dressed in a Western suit despite the hot sun and speaking as if he were imparting religious wisdom, said, “Learn A, B, C, D.” The temple is a gesture of defiance from the Dalits to the nation’s elite as well as a message to the Dalit young — English can save you.

A few days later, the Internet Corporation for Assigned Names and Numbers, a body that oversees domain names on the Web, announced a different kind of liberation: it has taken the first steps to free the online world from the Latin script, which English and most Web addresses are written in. In some parts of the world, Web addresses can already be written in non-Latin scripts, though until this change, all needed the Latin alphabet for country codes, like “.sa” for Saudi Arabia. But now that nation, along with Egypt and the United Arab Emirates, has been granted a country code in the Arabic alphabet, and Russia has gotten a Cyrillic one. Soon, others will follow.

Icann calls it a “historic” development, and that is true, but only because a great cliché has finally been defeated. The Internet as a unifier of humanity was always literary nonsense, on par with “truth will triumph.”

The universality of the Latin script online was an accident of its American invention, not a global intention. The world does not want to be unified. What is the value of belonging if you belong to all? It is a fragmented world by choice, and so it was always a fragmented Web. Now we can stop pretending — but that doesn’t mean this is a change worth celebrating.

Many have argued that the introduction of domain names and country codes in non-Latin scripts will help the Web finally reach the world’s poor. But it is really hard to believe that what separates an Egyptian or a Tamil peasant from the Internet is the requirement to type in a few foreign characters. There are far greater obstacles. It is even harder to believe that all the people who are demanding their freedom from the Latin script are doing it for humanitarian reasons. A big part of the issue here is nationalism, and the East’s imagination of the West as an adversary. This is just the latest episode in an ancient campaign.

A decade ago I met Mahatma Gandhi’s great-grandson, Tushar Gandhi, a jolly, endearing, meat-eating man. He was distraught that the Indians who were creating Web sites were choosing the dot-com domain over the more patriotic dot-in. He was trying to convince Indians to flaunt their nationality. He told me: “As long as we live in this world, there will be boundaries. And we need to be proud of what we call home.”

It is the same sentiment that is now inspiring small groups of Indians to demand top-level domain names (the suffix that follows the dot in a Web address) in their own native scripts, like Tamil. The Tamil language is spoken in the south Indian state of Tamil Nadu, where I spent the first 20 years of my life, and where I have seen fierce protests against the colonizing power of Hindi. The International Forum for Information Technology in Tamil, a tech advocacy and networking group, has petitioned Icann for top-level domain names in the Tamil script. But if it cares about increasing the opportunities available to poor Tamils, it should be promoting English, not Tamil.

There’s no denying that at the heart of India’s new prosperity is a foreign language, and that the opportunistic acceptance of English has improved the lives of millions of Indians. There are huge benefits in exploiting a stronger cultural force instead of defying it. Imagine what would have happened if the 12th-century Europeans who first encountered Hindu-Arabic numerals (0, 1, 2, 3) had rejected them as a foreign oddity and persisted with the cumbersome Roman numerals (IV, V). The extraordinary advances in mathematics made by Europeans would probably have been impossible.

But then the world is what it is. There is an expression popularized by the spread of the Internet: the global village. Though intended as a celebration of the modern world’s inclusiveness, it is really an accurate condemnation of that world. After all, a village is a petty place — filled with old grudges, comical self-importance and imagined fears.

SEARCH ENGINE OF THE SONG DYNASTY

Baidu.com, the popular search engine often called the Chinese Google, got its name from a poem written during the Song Dynasty (960-1279). The poem is about a man searching for a woman at a busy festival, about the search for clarity amid chaos. Together, the Chinese characters bi and dù mean “hundreds of ways,” and come out of the last lines of the poem: “Restlessly I searched for her thousands, hundreds of ways./ Suddenly I turned, and there she was in the receding light.”

Baidu, rendered in Chinese, is rich with linguistic, aesthetic and historical meaning. But written phonetically in Latin letters (as I must do here because of the constraints of the newspaper medium and so that more American readers can understand), it is barely anchored to the two original characters; along the way, it has lost its precision and its poetry.

As Web addresses increasingly transition to non-Latin characters as a result of the changing rules for domain names, that series of Latin letters Chinese people usually see at the top of the screen when they search for something on Baidu may finally turn into intelligible words: “a hundred ways.”

Of course, this expansion of languages for domain names could lead to confusion: users seeking to visit Web sites with names in a script they don’t read could have difficulty putting in the addresses, and Web browsers may need to be reconfigured to support non-Latin characters. The previous system, with domain names composed of numbers, punctuation marks and Latin letters without accents, promoted standardization, wrangling into consistency and simplicity one small part of the Internet. But something else, something important, has been lost.

Part of the beauty of the Chinese language comes from a kind of divisibility not possible in a Latin-based language. Chinese is composed of approximately 20,000 single-syllable characters, 10,000 of which are in common use. These characters each mean something on their own; they are also combined with other characters to form hundreds of thousands of multisyllabic words. Níhăo, for example, Chinese for “Hello,” is composed of ní — “you,” and hăo — “good.” Isn’t “You good” — both as a statement and a question — a marvelous and strangely precise breakdown of what we’re really saying when we greet someone?

The Romanization of Chinese into a phonetic system called Pinyin, using the Latin alphabet and diacritics (to indicate the four distinguishing tones in Mandarin), was developed by the Chinese government in the 1950s. Pinyin makes the language easier to learn and pronounce, and it has the added benefit of making Chinese characters easy to input into a computer. Yet Pinyin, invented for ease and standards, only represents sound. In Chinese, there are multiple characters with the exact same sound. The sound “băi,” for example, means 100, but it can also mean cypress, or arrange. And “Baidu,” without diacritics, can mean “a failed attempt to poison” or “making a religion of gambling.” In the case of Baidu.com, the word, in Latin letters, has slipped away from its original context and meaning, and been turned into a brand.

Language is such a basic part of our lives, it seems ordinary and transparent. But language is strange and magical, too: it dredges up history and memory; it simultaneously bestows and destabilizes meaning. Each of the thousands of languages spoken around the world has its own system and rules, its own subversions, its own quixotic beauty. Whenever you try to standardize those languages, whether on the Internet, in schools or in literature, you lose something. What we gain in consistency costs us in precision and beauty.

When Chinese speakers Baidu (like Google, it too is a verb), we look for information on the Internet using a branded search engine. But when we see the characters for băi dù, we might, for one moment, engage with the poetry of our language, remember that what we are really trying to do is find what we were seeking in the receding light. Those sets of meanings, layered like a palimpsest, might appear suddenly, where we least expect them, in the address bar at the top of our browsers. And in some small way, those words, in our own languages, might help us see with clarity, and help us to make sense of the world.

A WEB SMALLER THAN A DIVIDE

At first glance, there’s a clear need for expanding the Web beyond the Latin alphabet, including in the Arabic-speaking world. According to the Madar Research Group, about 56 million Arabs, or 17 percent of the Arab world, use the Internet, and those numbers are expected to grow 50 percent over the next three years.

Many think that an Arabic-alphabet Web will bring millions online, helping to bridge the socio-economic divides that pervade the region.

But such hopes are overblown. Although there are still problems — encoding glitches and the lack of a standard Arabic keyboard — virtually any Arabic speaker who uses the Web has already adjusted to these challenges in his or her own way. And it’s no big deal: educated Arabs are exposed, in various degrees, to English and French in school.

The very idea of an “Arabic Web” is misleading. True, before the Icann announcement declared that Arabic characters could be used throughout domain names, U.R.L.’s had to be written at least in part in Latin script. But once one passes the Latin domain gate, the rest is all done in Arabic characters anyway.

Nowadays almost every computer can be made to write Arabic, or any other script, and there is plenty of Arabic software. Most late-model electronic devices are equipped with Arabic. I text with friends using Arabic on my iPhone. Many computer keyboards are now even made with Arabic letters printed on the keys.

And where there’s no readily available solution, Arabic Internet users have found a way to adjust. Many use the Latin script to transliterate messages in Arabic when there’s no conversion program or font set available. Phonetic spelling is common. For sounds that have no written equivalent in Latin script, they’ve gotten creative: for example, the number 3 is commonly used for the “ayn” sound and 7 stands in for the “ha,” because their shapes closely resemble the corresponding Arabic letters.

So what will happen? In the short term, of course, some additional users will move to the Web, especially as they take advantage of the new range of domain names. Over time, though, this will peter out, because, as in most of the world, the digital divide still tracks closely with the material and political divide. The haves are the ones using computers, and many of them are also the ones long accustomed to working with Latin script. The have-nots are unlikely to have the luxury of jumping online. Changing the alphabet used to form domain names won’t exactly attract millions of poor Arabs to the Internet.

We should all celebrate the diversity that comes with an Internet no longer tied to a single alphabet. But we should be realistic, too. The Web may be a revolutionary technology, but an Arabic Web is not about to spur an Internet revolution.

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Bank Probes

An attempt to lay out exactly what’s known about which banks are being investigated by whom and for what.

Citigroup – The Wall Street Journal has reported that Citigroup is under “early-stage criminal scrutiny” by the Department of Justice. Fox Business reported on May 12th that the SEC has an active civil investigation into Citigroup and has

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subpoenaed the firm, but has not issued any Wells notices. A report on May 12th by the Journal reported that the Department of Justice is scrutinizing a few CDO deals that Morgan Stanley bet against–but which were underwritten by Citigroup and UBS. Neither the SEC nor the Justice Department have confirmed these reports. The New York Times has reported that New York Attorney General Andrew Cuomo is investigating eight banks to determine whether they misled rating agencies in order to get higher ratings for their mortgage-related products; Citigroup has been named as one of the banks under investigation in this probe. Subpoenas were issued on May 12th, according to the Times and the Dow Jones Newswires.

Credit Agricole, Credit Suisse – Have also both been named as part of the banks New York Attorney General Andrew Cuomo is investigating, which both The New York Times and Dow Jones Newswires have reported.

Deutsche Bank – The Wall Street Journal has reported that Deutsche Bank is under “early-stage criminal scrutiny” by the Department of Justice. Fox Business also reported on Wednesday that the S.E.C. has an active civil investigation into the bank and has subpoenaed it, but has not issued any Wells notices. Deutsche has also been named as one of the banks New York Attorney General Andrew Cuomo is investigating separately, which both The New York Times and Dow Jones Newswires have reported.

Goldman Sachs – The S.E.C. has brought a civil fraud lawsuit against Goldman, alleging that the investment bank made “materially misleading statements and omissions” when it allowed a hedge fund to help create and bet against a CDO, called Abacus, without disclosing the hedge fund’s role to investors. The Wall Street Journal, citing reported in April that the Justice Department has been conducting a criminal investigation into Goldman’s CDO dealings following a referral from the S.E.C. Neither agency has confirmed this, but the AP has reported the same thing. Since then, many sources–including the The New York Times, ABC News and the Washington Post–have also reported on the criminal probe, citing unnamed sources. No charges have been brought. Goldman has also been named as one of the banks New York Attorney General Andrew Cuomo is investigating separately, which both The New York Times and Dow Jones Newswires have reported. Goldman called the SEC’s accusations “unfounded in law and fact.” After the reports of a criminal investigation, a Goldman Sachs spokesman declined to confirm that the bank had been contacted by the DOJ but also told several news outlets that “given the recent focus on the firm, we’re not surprised by the report of an inquiry. We would cooperate fully with any request for information.”

JP Morgan Chase – The Wall Street Journal has reported that JP Morgan has received civil subpoenas from the S.E.C. and is under “early-stage criminal scrutiny” by the Department of Justice. Neither the S.E.C. nor the Justice Department have confirmed these reports. A spokesman from the bank told the Journal that it “hasn’t been contacted” by federal prosecutors and isn’t aware of a criminal investigation.

Merrill Lynch – It has not been named in any S.E.C. investigations. But as ProPublica pointed out, a lawsuit brought by a Dutch bank asserts that Merrill Lynch did a CDO deal that was “precisely” like Goldman’s. The S.E.C. has declined to comment on whether it was investigating the deal. Merrill has also been named as one of the banks New York Attorney General Andrew Cuomo is investigating separately, which both The New York Times and Dow Jones Newswires have reported. Merrill has denied the similarities between its CDO deal and Goldman’s, calling Goldman’s Abacus deal an “entirely different transaction.” The bank did not immediately return the Times’ request for comment about the investigation by the New York attorney general, but when we called and asked, a spokesman from Bank of America, which merged with Merrill, said “we are cooperating with the Attorney General’s office on this matter.”

Morgan Stanley – The Wall Street Journal reported on May 12th that the Justice Department has been conducting a criminal investigation into Morgan Stanley’s CDO dealings, including its role in helping design and betting against two sets of CDOs from 2006 known as Jackson and Buchanan. The Justice Department declined to comment. No charges have been brought, and according to the Journal, the probe is “at a preliminary stage.” A Morgan Stanley spokeswoman said the bank had “no knowledge of a Justice Department investigation into these transactions.” The Journal reported that the S.E.C. has subpoenaed Morgan Stanley on several occasions, but the bank has denied receiving any Wells notices, which would indicate pending S.E.C. charges. Morgan has also been named as one of the banks New York Attorney General Andrew Cuomo is investigating separately, which both The New York Times and Dow Jones Newswires have reported. Aspokeswoman of the bank said that it has “not been contacted by the Justice Department about the transactions being raised by the Wall Street Journal, and we have no knowledge of a Justice Department investigation into these transactions.” The investment bank declined to comment to the Times about the New York attorney general’s investigation.

UBS – The Wall Street Journal reported that UBS has received civil subpoenas from the S.E.C. and is under “early-stage criminal scrutiny” by the Department of Justice. In a report on May 12th that also relied on “people familiar with the matter,” the Journal reported that the Justice Department is scrutinizing a few CDO deals that Morgan Stanley helped design and bet against–but which were marketed by Citigroup and UBS. Neither the SEC nor the Justice Department have confirmed these reports. The firm has not disclosed that it has gotten any Wells notices. UBS has also been named as one of the banks New York Attorney General Andrew Cuomo is investigating separately, which both The New York Times and Dow Jones Newswires have reported.

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Fast Trading

On Thursday afternoon, the Dow plunged 1,000 points within a few minutes, followed by an equally sudden recovery. We don’t know all the details about the drop, but it was almost certainly the result of computer or human error in a high-speed trading program.

Among the many arcane corners of the financial world highlighted by the Wall Street crisis, high-frequency trading — in which computers scan billions of bits of market data for trading opportunities that may exist for mere fractions of a second — has generated a surprising amount of discussion. Alongside the risk of expensive errors like what happened Thursday, critics say, these programs facilitate insider trading and overwhelm regulators’ access to critical information.
These are fair criticisms. Fortunately, they can also be easily addressed without undermining the positive role that high-frequency trading plays in the market.
Let’s start with the insider trading charge. Often, when an exchange operator receives an investor order and finds that another exchange has a better price, it will “flash” the order to a few select traders in its exchange a split second before sending it to market, giving those traders an opportunity to improve their price, too. When used properly, flashing ensures that investors trade at the best available prices.
But that hair’s breadth of time also gives high-frequency traders an opportunity to make a tidy profit off what amounts to insider information. How? Rather than improve their price, the recipient of a flash can go to the other exchange, buy up all the assets at better prices, and force the original investor to trade with them at an inferior price.
We don’t allow trading based on private knowledge of pending business deals or court rulings, and we shouldn’t allow it in high-frequency trading, either. But that doesn’t mean we should ban flashing all together. Instead, to deter abuse, anyone who gets a preview of a trade, whether by phone or flash, should be required to register with an exchange and keep records of every negotiation.
A trickier problem lies with the software that handles the trades. Heavy use of any software will magnify even the smallest flaw — and when it comes to high-frequency trading, a tiny flaw can put millions of dollars at risk before anyone notices.
One plausible explanation for Thursday’s 16-minute crash and recovery, for example, is that computers programmed to sell when prices hit a certain level did so en masse, prompting yet other computers to do the same, until the prices of some stocks were pushed down to nearly zero. Then other computers, recognizing these as extraordinarily unreasonable prices, began buying them up with equal relish.
Indeed, the rapid development of automated-trading software and the maddening complexity of even the most simple systems make the introduction of technological errors inevitable. While it’s true that electronic exchanges require trading software to be certified before it is used, there is no market-wide standard for testing the software and nothing to effectively stop a firm from trading with uncertified software.
Financial regulators should take a page from the Federal Aviation Administration and the National Transportation Safety Board and develop quality standards for trading software, as well as investigatory procedures that would allow the industry to learn from episodes like Thursday’s.
Finally, the Securities and Exchange Commission needs better access to the fire hose of data hitting the market each day. Because a great number of trades go through middlemen, regulators have no easy way of even knowing who the high-frequency traders are. With millions of trades made every day, this administrative hurdle means traders are essentially anonymous to regulators.
This opacity allows firms to reap benefits intended for nonprofessional investors. Many exchanges, for example, have rules that require them to fill orders from retail investors before those from pros. Anonymity allows professionals to masquerade as amateur investors and thus get their trades in faster.
But there’s an easy solution here as well: the Securities and Exchange Commission should require that everyone who originates a trade be identified. The commission is reported to be working on just such a rule, and it can’t come soon enough. Otherwise, it’s akin to asking someone to officiate a football game wearing a blindfold.
Like the autopilots that control most airplanes nowadays, high-frequency trading is more beneficial than harmful. It automates the routine elements of a complicated and high-risk mission, reducing the likelihood of human error. But costly errors will still happen, and some traders will bend the rules beyond the breaking point. We need reforms that actually address the risks of high-frequency trading and facilitate the restoration of public confidence in the markets.

– The country does not have fixed-term parliaments but elections must be held at least every five years.

– Britain operates a first-past-the-post voting system for general elections in which England, Wales, Scotland and Northern Ireland are divided up into 650 constituencies.

– Parliamentary constituencies historically each comprise roughly 70,000 voters but the boundaries are only redrawn every decade or so, and currently vary in size from 22,000-110,000 voters. Each elects one MP (member of parliament) who sits in the House of Commons.

– Every person in that constituency can cast one vote for who they want to be their MP. Voters do not directly elect the prime minister.

– Assuming a party secures an overall majority – at least 326 members – in the House of Commons, its leader is asked by Queen Elizabeth II to form a government and also becomes Prime Minister.

– If no party has an overall majority in the House of Commons, there will be a hung parliament – an extremely rare event in Britain that had not happened since 1974.

– This could lead to a minority or coalition government.

– However, the precedents for this lasting long-term are not promising – in 1974, two elections were held within nine months to resolve the situation.

– As well as being leaders of their parties, Labour Prime Minister Gordon Brown and Conservative Leader David Cameron are also constituency MPs.

But it also has at least one major flaw: it would not do enough to prevent taxpayers from paying the bill for a future crisis.

What would? A tax on banks. The International Monetary Fund has started pushing for a bank tax, and a tax has also become part of the debate in Britain’s election campaign. In this country, however, the subject has taken a back seat to issues like derivatives regulation and the Goldman Sachs case. Those other issues are important, but they are not as central to minimizing the damage from the next crisis.

To understand why, let’s take a glimpse into the future. Imagine the year is 2020,
and a major financial firm is collapsing.

The financial regulation bill that President Obama signed back in 2010 was meant to deal with just such a problem. It gave regulators something called “resolution authority.” They could seize a dying firm, wipe out its shareholders, fire its top executives and keep it operating until its surviving parts could be sold off in an orderly fashion. Now, in 2020, the regulators are preparing to use that authority for the first time.

But as they dig into the details, they realize they are facing a raft of problems. One of the biggest is that the firm has 70 percent of its assets abroad (roughly the share of Citicorp’s business that was overseas in 2009). Washington can’t simply seize
assets held in London, Shanghai or Moscow.

So ultimately, the regulators are left with the same choice that arose in 2008: bankruptcy or bailout. Regulators can let the firm fall apart suddenly and risk the kind of collateral damage that the bankruptcy of Lehman Brothers caused. Or they can spend billions of taxpayer dollars propping up the firm, as was the case with A.I.G. It’s a miserable choice.

You also can be pretty sure which of the two options tomorrow’s policy makers will choose: bailout. History — in the form of the Great Depression and, more recently, Lehman — argues against the idea of liquidate, liquidate, liquidate, as Herbert Hoover’s Treasury secretary, Andrew Mellon, advocated. The downside, of course, is that taxpayers end up paying for Wall Street’s sins.

Obama administration officials insist that the reregulation plan will prevent this outcome. They note that both the Senate and House bills will give regulators more authority to monitor financial firms. Banks will also be required to hold more cash in reserve, which will give them a bigger cushion when some investments do go bad. The rules for resolution authority, meanwhile, will be written with international cooperation in mind.

And maybe time will prove the administration correct. But a good number of economists and banking experts are worried. They think the odds of a future bankruptcy-or-bailout dilemma will remain uncomfortably high even if reregulation passes.

For starters, there are the cross-border problems; in the midst of a crisis, governments may have trouble cooperating. Then there is the fact that the regulators have never before tried to shut down anything as complex as a multibillion-dollar financial firm. “It’s really hard — really hard,” says Robert Steel, who worked on the financial crisis in the Bush Treasury Department and later was chief executive of Wachovia. “Anyone who says they know exactly what we should do is overconfident.”

Another former top government official adds, bluntly, “Don’t kid yourself into thinking that if J. P. Morgan were on the rocks, it would disappear.”

Above all, no one knows what the next crisis will look like. So no one can be sure exactly how to prevent it. In all likelihood, Wall Street will eventually figure out ways around technocratic rules — and technocrats — and create trouble that today’s proposals don’t anticipate.

The beauty of a bank tax is that it acknowledges as much. Financial firms play a vital role in a market economy. But they also have a long record of causing crises, be it the South Sea bubble of 1720, the Panic of 1873, the Great Depression or our own Great Recession. A bank tax is akin to an insurance policy that taxpayers would require Wall Street to hold. The premiums on that policy would keep Wall Street from making big profits in good times while foisting its losses on society in bad.

The current Senate bill includes a kind of bank tax, but it has all kinds of problems. It would initially collect only $50 billion from firms and then set the money aside to pay the costs of future bailouts. Other crises have cost far more than $50 billion.

For this reason, the Obama administration prefers a postcrisis tax. The White House has proposed a so-called TARP tax, to raise at least $90 billion over the next decade and cover the costs of the 2008 bailout fund (the Troubled Asset Relief Program). But this idea has its own flaws. It does not leave any money for future busts. It assumes Washington will always be able to recoup those costs later, which doesn’t sound like a great bet.

The I.M.F. prefers a permanent tax, for the good reason that the risk of crises is permanent. “The challenge is to ensure that financial institutions bear the direct financial costs that any future failures or crises will impose — and maybe somewhat more, given all the other costs that bank failure can impose on the economy,” Carlo Cottarelli, the head of the I.M.F.’s fiscal affairs unit, wrote last weekend. The tax wouldn’t go into a dedicated bailout fund. Its purpose instead would be to discourage too much risk-taking and, over the long term, help offset any bailout costs.

Because the tax would be calculated based on a firm’s holdings, a small local bank or a larger bank with billions of dollars in safe consumer deposits might pay nothing. A leveraged investment bank would surely be taxed.

The TARP tax, in its technical design, would be similar. And Timothy Geithner, the Treasury secretary, told me recently that he was open to the idea of the tax’s becoming permanent. “There is a very good argument you should put a fee on finance, like a tax on pollution,” he said.

Yet the administration — nervous about upsetting the fragile support in Congress for financial reregulation — has been afraid of making the tax part of the broader bill. That strikes me as a mistake, given the tax’s importance. Obviously, though, if Congress passes a bank tax in a separate bill later this year, it will work out the same in the end.

There is some reason for optimism, too. Max Baucus, the chairman of the Senate Finance Committee, told Politico this week, “I don’t think there’s much doubt that there will be a bank tax.” Why? The tax is not just about punishing banks.

The federal government, remember, is facing a huge deficit. To pay it off, Washington will need to make spending cuts and raise taxes. Can you think of a better candidate for taxation than an industry that made huge profits during the boom and then helped cause the bust that has sent the deficit soaring? NY Times

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Goldman Sachs Case

1. This is a Weak Case: Actually, no — it’s a very strong case. Based upon what is in the SEC complaint, parts of the case are a slam dunk. The claim Paulson & Co. were long $200 million dollars when they were actually short is a material misrepresentation — that’s Rule 10b-5, and its a no brainer. The rest is gravy.

2. Robert Khuzami is a bad ass,no-nonsense, thorough, award winning Prosecutor:This guy is the real deal — he busted terrorist rings, broke up the mob, took down security frauds. He is now thedirector of SEC enforcement. He is fearless, and was awarded the Attorney General’s Exceptional Service Award (1996), for “extraordinary courage and voluntary risk of life in performing an act resulting in direct benefits to the Department of Justice or the nation.”

When you prosecute mass murderers who use guns and bombs and threaten your life, and you kick their asses anyway, you ain’t afraid of a group of billionaire bankers and their spreadsheets. He is the shit. My advice to anyone on Wall Street in his crosshairs: If you are indicted in a case by Khuzami, do yourself a big favor: Settle.

3. Goldman lost $90 million dollars, hence, they are innocent: This is a civil, not a criminal case. Hence, any mens rea — guilty mind — does not matter. Did they or did they not violate the letter of the law? That is all that matters, regardless of what they were thinking — or their P&L.

4. ACA is a victim in this case: Not exactly, they were an active participant in ratings gaming. Look at the back and forth between Paulson’s selection and ACAs management. 55 items in the synthetic CDO were added and removed. Why?

What ACA was doing was gaming the ratings agencies for their investment grade, Triple AAA ratings approval. Their expertise (if you can call it that) was knowing exactly how much junk they could include in the CDO to raise yield, yet still get investment grade from Moody’s or S&P. They are hardly an innocent party in this.

5. This was only one incident: The Market sure as hell doesn’t think so — it whacked 15% off of Goldman’s Market cap. The aggressive SEC posture, the huge reaction from Goldie, and the short term market verdict all suggest there is more coming.

If it were only this one case, and there was nothing else worrisome behind it, GS would have written a check and quietly settled this. Their reaction (some say over-reaction) belies that theory. I suspect this is a tip of the iceberg, with lots more problematic synthetics behind it.

And not just at GS. I suspect the kids over at Deutsche bank, Merrill and Morgan are working furiously to review their various CDOs deals.

6. The timing of this case is suspect. More coincidental, really. The Wells notice (notification from the SEC they intend to recommend enforcement) was over 8 months ago. The White House is not involved in the timing of the suit itself, it is a lower level staff decision.

7. This is a Complex Case: Again, no. Parts of it are a little more sophisticated than others, but this is a simple case of fraud/misrepresentation. The most difficult part of this case is likely to turn on what is a “material omission.” Paulson’s role in selecting mortgages may or may not be material — that is an issue of fact for a jury to determine. But complex? Not even close.

8. The case looks thin: What we see in the complaint is the bare minimum the prosecutor has to reveal to make their case. What you don’t see are all the emails, depositions, interrogations, phone taps, etc. that the prosecutors know about and GS does not. During the litigation discovery process, this material slowly gets turned over (some is held back if there are other pending investigations into GS).

Going back to who the prosecutor in this case is: His legal reputation is he is very thorough, very precise, meticulous litigator. If he decided to recommend bringing a case against the biggest baddest investment house on Wall Street bank, I assure you he has a major arsenal of additional evidence you don’t know about. Yet.

Typically, at a certain point the lawyers will tell their client that the evidence is overwhelming and advise settling. That is around 6-12 months after the suit has begun.

9. This case is political: I keep hearing that phrase, due to the SEC party vote. It is incorrect. What that means is the case is not political, it means it has been politicized as a defense tactic. There is a huge difference between the two.

10. I’m not a lawyer, but . . . Then you should not be ignorantly commenting on securities litigation. Why don’t you pour yourself a tall glass of STF up and go sit quietly in the corner.

I have $1,000 against any and all comers that GS does not win — they settle or lose in court. Any takers? My money is already in escrow — waiting for yours to join it. Winnings go to the charity of the winners choice.

********************

Derivatives

Financial contracts that derive their value from some other factor. It’s like betting on an NBA game. You could bet on the final score, or you could take a coupon from Taco Bell offering a free taco if the home team scores more than 100 points. That offer is a derivative, a financial bet that pays off only if some external event comes true. And you can trade that, because it has value.

At stake in the current debate is how many derivatives — which are private, undisclosed deals — should be forced onto public exchanges, where regulators can see which banks have a hand in which deals. That was one of the reasons why the Crash of ’08 was so severe — no one knew exactly who owed what to whom in the $450 trillion derivatives market, and that froze the entire financial system.

But the politics of derivatives stretch far beyond Wall Street. Big farmers use derivatives all the time — to hedge their bets in case the weather goes bad, for instance. Austan Goolsbee, White House economic adviser. Politico

WILD HORSES

Harrowing Ride

Audio Portrait

East Village in the 80s through my answering machine. Greeting messages, friendly voices, a recorded ecstasy and many tongues were left on tape for me to remember. Now I'm sharing it all with you. Enjoy it.

World Cup
in S.Africa.
Remember?

Joyce's 'Ulysses'
as Graphic Novel

The illustration above is one of the plates of "Ulysses 'Seen,'" a high quality graphic adaptation by Robert Berry of James Joyce's masterpiece "Ulysses."
For those who never got around to read the long, uninterrupted, controversial June 16, 1904, conversation by Molly Bloom, Stephen Dedalus and others, that the great Irishman envisioned in Dublin, you won't have a better chance to do it.
And for those already familiar with the book form, it's another opportunity to appreciate this enduring work of literature through the eyes of a contemporary artist.
In either case, a few pints of Guinness to go along with it are absolutely optional.

EPITAPH

"Alone we are born, and die alone;
Yet see the red-gold cirrus
Over snow-mountain shine.
Upon the upland road
Ride easy, stranger:
Surrender to the sky
Your heart of anger."

FALSE ALARM

Desmodus

The Artist

Father & Son

Fireball Over Midwest Skies

COLL POLL

The Numbers Are In

Voting stations are closed at this time. The final tally was 13 votes in favor of Coll getting a cellphone and two against it.

MAY 19th IS COLL'S BIRTHDAY & HE WON!

This decision is final. Thank you all for participating. Coll's most heartfelt gratitude goes for the kind souls who voted in favor. For the two heartless hacks who were against it (you know who you are), a SWAP team graciously volunteered to pay you a visit first thing tomorrow morning. Stop by the front desk to request a waiver to present to your teacher, boss or dominatrix. Call your mother. Enroll in a charitable cause. Volunteer at a Soup Kitchen. Run to raise funds for Aids. This is our last broadcast. Please tune in for future promotions. This tape will self-destroy in five seconds. No further ado will come out of nothing. (5/19/2010)

MOTION

CLUTCH

Off-Key Note

Writings, pictures, videos, comments & more, edited by a writer, musician and world citizen living in downtown
New York City.
Acting gigs, a few screenplays and endless clashes with reality.
Brazilian by birth, multilingual by chance, cash strapped as usual.
Agnostic but partial to great soccer. Unmoved by sunsets, campaign speeches, the religious pull or any sure bet.Poor vision and lower back pain. A bottomless pit for a navel. Blue, cats, 9, left, heat and outer space.
Common ground needs not to apply. Not accepting advice at this time.

Naked City

“In Italy, for thirty years under the Borgias they had warfare, terror, murder and bloodshed, but they produced Michelangelo, Leonardo Da Vinci and the Renaissance. In Switzerland, they had brotherly love, five hundred years of democracy and peace – and what did they produce? The cuckoo clock.”

Slideshow

LAST WORDS

* - "Let's do it."GARY GILMORE, executed by firing squad in Jan. 17, 1977, by the State of Utah, for murdering a model clerk. He was the last person to be executed in the U.S. in that fashion until June 18, 2010, when Ronnie Lee Gardner was shot to death also by Utah.

Norman Mailer wrote "The Executioner's Song," which he called a "true story," based on the relationship he established with Gilmore, a confessed killer, and the state of affairs of the U.S. in the 1970s. The book doesn't shy away from the horrific facts surrounding his murderous spree, but in a way it tones them down and shifts the focus to the society's possible role as a fertile ground for such deviant behavior.